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Plugged In

Tough Times in Techland as IT Budgets Snap
Shut

By

Mark Veverka

Updated Oct. 8, 2001 12:01 a.m. ET

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As readers over the past few years have come to expect from this corner of Barron's, we tend to look at the darker side of techland -- even when things are frothy, such as during the halcyon days of the bubble.

The froth is long gone now. But we still can't help it. Whenever we peer deep into the heart of the metaphysical Silicon Valley, which stretches from San Jose to Boston and Austin to Seattle, we just don't see a heck of a lot of sunshine. This is especially true in the wake of September 11.

Thus, it comes as no surprise that the nation's top technology officers are now balking at Information Technology purchases more than before that horrible day -- as reported in the latest poll conducted by Deutsche Banc Alex. Brown economist Ed Yardeni and CIO Magazine.

Prior to the September 11 attack, the poll suggested that tech spending might have hit bottom in May and was beginning to rebound. But in the latest survey, conducted between September 13 and September 20, that trend has now been reversed. Chief information officers say they reacted to the terrorist attacks and anticipated retaliatory strikes by slashing their projected IT budgets, cutting the growth rate of corporate tech spending over the next 12 months to about 3.5%. That compares with growth rates in tech spending of 7.2% in August and 18% in September of 2000, according to the pollsters.

"There was a clear pattern of recovery. I think there was a growing sense that we were hitting bottom and earnings were going to improve," Yardeni told Barron's in an interview. "Not surprisingly, the CIOs lowered their expectations over the next six months in response to the attacks."

For example, 42% of the CIOs indicated a willingness to increase spending on computer hardware in August 2001. Now, as of September, only 30% say they will spend more.

After two years of underspending on hardware, according to Yardeni, it was time for many companies to upgrade desktop computers and servers. And he wonders how much of the survey had been biased by its timing. That is, because the poll came so immediately after the traumatic events, there might have been some overreaction that could get corrected by the next Yardeni/CIO poll in October.

"What we don't know was, how much of that was a knee-jerk reaction?" Yardeni wonders. "CIOs don't necessarily make unilateral decisions. Nobody changes their IT budgets overnight like that." Thus, the harsh turn for the worse reflected in the latest poll "might soften before the end of the year, if it hasn't already," the economist says.

The one bright spot is storage. With data-protection and recovery products getting tested to the hilt by displaced financial companies, data storage managed to avoid any dropoff in anticipated spending. About 48.5% of the CIOs say they still intend to spend more on storage. "Storage is holding up remarkably well," Yardeni says.

More important, as CIOs currently sit down to make their budgets for next year, is the answer to this question: How much more -- as a result of the gloom and unpredictability of this fall -- will the decision-makers now rein in of spending for 2002? Because as far as we are concerned, nothing is more crucial to the financial performance of technology companies -- and the strength of their shares -- than corporate IT spending. As IT spending goes, so goes tech.

Beyond the trauma and psychological factors is the basic reality that the once-teetering economy is now stressed beyond the brink -- with supply channels and means of transport dramatically impeded due to the unforeseen disruption of air travel. "Weak profits and tight credit conditions remain major drags on IT spending," Yardeni notes.

But the September survey shows that the importance of financial conditions has grown in the eyes of CIOs. When asked to cite "the No. 1 negative for IT spending," the top factor they cited was weak profits.

But the percentage of respondents blaming profits slipped from about 40% in August to 36% in September. In the meantime, "tight financial conditions," the second-most-frequent response, gained slightly in September over August.

When all is said and done, only when corporate profits begin to show a steady, healthy recovery will tech spending truly enjoy new growth.

"The key is going to be profits," says Yardeni. "Technology spending is still capital spending. That's what we learned last year. And at the end of the day, capital spending is determined by profits." He predicts that corporate profits will start showing signs of life by the first quarter of next year.

Consequently, he anticipates that increases in technology spending will follow in the second quarter of 2002.

"Technology capital spending is not going to lead us out of this recession," Yardeni professes. Seventy-six percent of the CIOs say that they expect IT spending in the third quarter of 2001 to be as weak or weaker than in the second quarter.

Thus, it is up to profits, which means it is up to the consumer. The Federal Reserve just dropped interest rates another half-percentage-point, and President Bush is seeking $60-75 billion in fiscal stimulus to jump-start the sagging economy.

So far, consumer spending has been relatively buoyant, all things considered. But as layoffs mount, even optimists have to wonder when the mighty consumer may begin to crack under the pressure.

The buzz last week was that
Dell Computer
was going to miss its earnings targets for the third quarter. But lo and behold, the company launched a news missive saying that it was taking share, and that it still expected to meet analysts' targets for the quarter. We guess that qualifies as news these days. Certainly tech investors thought so as they bid up some of their favorites last Thursday.

Yet, if anything, the Dell announcement sure seemed like a dart aimed at the proposed merger of
Hewlett-Packard
and
Compaq Computer.
How could it be that Compaq Chief Executive Michael Capellas just days earlier warned that his company was going to miss by a mile, blaming acts of God (a hurricane), acts of war (the terrorist attacks) and acts of desperation (Compaq's shotgun marriage to HP) for the fact that his maker of boxes was flailing. To be sure, the twin pre-announcements definitely rated as A Tale of Two ... PC makers.

"Compaq says things are really awful, and then Dell comes out and says it will meet its guidance," says Toni Sacconaghi Jr., a Sanford C. Bernstein hardware analyst. "The feared consequences of the merger are happening as Compaq customers migrate away. The people who were selling [Compaq] earlier are now saying, 'We knew this would happen.' "

If nothing else, Compaq's warning vis-&agrave;-vis Dell's anti-announcement underscores just how beleaguered Compaq really is, demonstrating to shareholders that they have no other option but to pray the HP deal goes through. Because without the Carly Fiorina Executive Employment Preservation Act of 2001, Compaq likely would sink. And HP would be applying triage to myriad failing business units, instead of hiding behind the accounting obfuscation of a mega-merger.

Sacconaghi has been scratching his head, trying to handicap whether the HP/Compaq deal will see the light of day. For one thing, "the arbitration spread has been reasonably high." What's more, management has demonstrated unequivocal conviction to ensure that the merger goes through. In addition, Compaq shareholders have little choice but to approve the marriage, despite an almost-unheard-of negative buyout premium for their shares.

HP has about 1.8 billion shares outstanding. After the deal adding Compaq shares, the combined company would have about three billion shares. Considering that HP's printing and imaging business accounts for more than 100% operating profit, the impact of that cash cow on the merged company's bottom line will be diminished, Sacconaghi notes. He says printing and imaging accounts for about 43% of HP's revenues prior to a merger, but only about 20% after. Thus, HP shareholders see the value of their stock diluted as Compaq adds little or no value to their investments.

Tough Times in Techland as IT Budgets Snap
Shut

As readers over the past few years have come to expect from this corner of Barron's, we tend to look at the darker side of techland -- even when things are frothy, such as during the halcyon days of the bubble.

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